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Virtual Currency: Bitcoin and Beyond, Part 1

Even with virtual currency’s notorious growing pains, a “bitcoin economy” that promises to challenge, excite, and worry CIOs and other business leaders continues to develop and expand.

Despite an explosion in media coverage, bitcoin, litecoin, and other virtual currencies are still widely misunderstood. Every day, news articles describe exchange meltdowns, price volatility, and government crackdowns related to bitcoin. This focus on bitcoin as a volatile and even renegade currency may be distracting governments and businesses from addressing its potential long-term significance as a disruptive new money technology.

Bitcoin is more than just a new way to make purchases. It is a protocol for exchanging value over the Internet without an intermediary like a bank or a credit card company. Although much has been written about the payment applications supported by bitcoin, including remittances, micropayments, and donations, it has the potential to disrupt all manner of systems related to property transfers, the execution of contracts, and other transactions that rely on intermediaries.

As the bitcoin ecosystem evolves and more use cases emerge, the public and private sectors will face challenges, opportunities, and responsibilities related to it. Governments may need to write new regulations and even new laws to accommodate bitcoin, while corporations may need to incorporate bitcoin into their strategic planning. Bitcoin could ultimately revolutionize the way we conduct business and think about work. The sooner the public and private sectors understand its potential, the better prepared they will be to mitigate the risks and capture the benefits afforded by bitcoin and other virtual currencies.

Bitcoin 101

Though users may acquire bitcoins in any number of ways—e.g. transactions, gifts, etc.—many new users purchase their first bitcoins with U.S. dollars or other hard currencies at special online exchanges. The network that makes it possible for users to transfer their coins to another party as part of a transaction is based on a shared public ledger system known as the block chain, which contains a record of every transaction ever processed. Much like a bank uses its own internal systems to record and process financial transactions, bitcoin’s block chain uses a peer-to-peer network of personal computers owned by select group of users called “miners” who process and validate all transactions using cryptography.

Miners’ computers are fitted with special hardware and software that “listen” for transactions taking place within the greater bitcoin network. To process and ultimately record these transactions in the block chain, miners verify two facts already addressed by current payment systems such as credit cards. The first is that when User A transfers a bitcoin to User B, User A has a bitcoin to spend (thus preventing counterfeiting). The second is that when User A transfers a bitcoin to User B, User A is not simultaneously transferring the same bitcoin to an additional User C (thus preventing double spending).

In return for allowing their computers to be used this way, miners are rewarded with—you guessed it—bitcoins.

Bitcoin has three qualities that distinguish it from other currencies and payment systems.

First, unlike current payment systems, bitcoin is peer to peer, transferring value directly over the Internet without an intermediary. As a result, bitcoin has been referred to as “Internet cash”, as it can be exchanged from person to person much like paper currency today.

Second, bitcoin is open, yet securely authenticated. Traditional payment systems rely on the privacy of transaction information to maintain security. For example, the compromise of a credit card transaction can result in the release of valuable information that can be used to conduct future transactions. In comparison, bitcoin relies on cryptography. As every transaction is validated by the network of miners, bitcoin functions because of its openness, not despite it.

Third, bitcoin is self-propelling. Bitcoin uses its own product, bitcoins, to reward or “pay” miners who serve as the engine of the system. As a result, the system requires far less overhead than traditional payment systems. In this sense, it functions because of those participating in the system.

These three characteristics largely explain bitcoin’s appeal, enabling a nearly frictionless global payment system. However, these same factors have also created risks and deterrents.

Next up: In the second article in this two-part series, we examine security, volatility, and regulatory challenges bitcoin and other virtual currencies may face on the path to wider adoption.

About Deloitte Insights

Deloitte Insights for CIOs couples broad business insights with deep technical knowledge to help executives drive business and technology strategy, support business transformation, and enhance growth and productivity. Through fact-based research, technology perspectives and analyses, case studies and more, Deloitte Insights for CIOs informs the essential conversations in global, technology-led organizations. Learn more.

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